A Causal Linkage: Corporate Debt and Sovereign Spreads

This study shows that corporate debt accumulation during credit booms can explain increases in sovereign risk during stress periods. Using detailed firmlevel database across six Eurozone countries, I construct granular instruments for aggregate corporate leverage. Instrumental variable regressions indicate that rising corporate leverage causally increases sovereign spreads in Eurozone countries during the debt crisis period of 2010-2012. This result provides the first empirical evidence on the causal link between corporate debt and sovereign debt crises. Additionally, firm-level evidence suggests that highly leveraged firms are likely to pay fewer taxes to the government, contributing to the rise in sovereign risk.